mg's derivatives

8/2/2019 MG's Derivatives

1/25

DERIVATIVE DEBACLES


2/25

In 1993 a report was publishedwidely by a group of 30, whichwas about the risk associatedwith the derivatives.

The group consisting themembers ofInternational

Financial Community.

The group initiated four kind ofrisks associated with

derivatives, which are:


3/25

Market Risk : The risk to earningsfrom adverse movements inmarket prices.

Operational Risk : The risk oflosses occurring as a result ofinadequate systems and control,human error, or managementfailure.

Counterparty Credit Risk :The riskthat a party to a derivative contractwill fail to perform on itsobligation.


4/25

Legal Risk : The risk of loss because acontract is found not to be legallyenforceable.

Derivatives are legal contracts.

Like any other contract, they requirea legal infrastructure.

These four kind of risks are not

unique to derivative instruments. They are the same types of risks

involved in more traditional types offinancial intermediation, such asbanking and securities underwriting.


5/25

The rapid growth of derivativetrading in recent years poses somespecial problems for the financialmarkets.

It also reflects advances in thetechnology of risk management.

The conventional wisdom viewsderivative markets as markets forrisk transfer.

The derivative markets do notcreate new risks, they just facilitaterisk management.


6/25

Introduction


7/25

Metallgesellschaft A.G.

a. 14th largest corporation inGermany.

b. Conglomerate with interest in

metal, mining and engineeringbusinesses and 15 subsidiaries.

MG Refining & Marketing ( MG )

a. US oil trading subsidiary.b. New entrant to US market, lowmarket share.

c. Goal to develop a fullyintegrated oil business in US.


8/25

Dr.Heinz C. Schimmelbusch( CEO of MG )

He started his career in 1973 withMetallgesellschaft AG, Germanywhere he rose to the position of

the Chairman of theManagement Board.


9/25

In 1989 the company obtained 49% of stake inCastle Energy, U.S oil exploration company.

Purchased output of refined products atguaranteed margins on a long term contacts.

In 1992,1993 singed a large number of long termcontracts with independent retailers.

Delivery ofgasoline , heating and jet fuel oil.


10/25

MGRM contacts to buy all the refined outputsfrom the castle energy for 10 years.

Estimated volume 126,000 barrels/day (460M barrels over the next 10 years ).

Guarantees a fixed margin to castle energy.


11/25

MG developed 3 types of contract programs.

Firm Fixed : Under firm fixed a customer agreed to fixed monthlydeliveries at fixed prices.

Firm Flexible : Similar to the previous but giving customersextensive rights, to set the delivery schedule. MG was obligated toa total of 52M barrels.

Guaranteed Margin : Under which MG agreed to make deliveriesat a price that would assure a customer a fixed margin, relative tothe price offered by its geographical competitors.

$3-$5 built in margin per barrel.


12/25

MG was a New entrant to the U.S oil market.

MG didnt had a significant market share.

MG had No competitive advantage in its cost ofsupply.

MG spotted that what it thought was aninnovative marketing strategy, to sell financialpetroleum to the independent and quasi-independent retailers.


13/25

MG embedded a cash out option on its supplycontracts.

If energy prices rise above the contract price,counterparty can sell-back the remainingforward obligations for differences betweenthe near-term futures price and contractedfutures price.

MG`s protection to customer from the defaultrisk, which further creates liquidity risk forcustomer.


14/25

MG hedged the risk of rising oil prices with both short datedenergy future contacts and OTC swaps.

MG`s total derivative position was 160M ( barrel for barrel )

The hedging strategy MG used was known as Rolling Forward .

Key aspects of this strategy were:

1) Concentrated on the short dated futures and swaps.

2) Position had to be rolled forward monthly, with downwardadjustment for the delivered oil to keep 1:1 ratio.


15/25

If futures prices are below spotprices, Backwardian.

If futures prices are above spotprices,Contango.

In a typical commodity market,the futures will be above spot,i.e., the market will be incontango.

In some commodity markets(especially oil) futures priceshave remained below spot for

long periods of time.


16/25

MGRMs stack-and-roll hedgingstrategy exposed it to basis risk.

Because the price behavior of itsstack of short-dated oil contractsmight diverge from that of its long-term forward commitments.

the behavior of energy futuresprices became most unusual in1993.

Prices followed Contango InsteadofBackwardian.


17/25

MGRM was forced to pay a premium toroll over each stack of short-termcontracts as they expired.

These rollover costs reflected the costof carry normally associated withphysical storage.

Management Feared that these rollovercosts could add further to MGRMs

losses.

chose to liquidatethe subsidiaryshedge and terminate its long-termdelivery contracts with its customers.


18/25

oil prices began rising in 1994,soon after MGRMs newmanagement lifted the firmshedge.

It thus appears that MGRMcould have recouped most ifnot all of its losses by simply bysticking to its hedgingprogram.

Criticisms of MGRMs hedgingprogram have focused on twoissues:


19/25

1) Assumptions of theMGRMs Hedging strategyarchitects :

Key Question was whetherthe change was Temporary

or persisted.

Soybeans & copper Example:


20/25

2) Steps MGRM could have taken to

reduce the variability of its cash flows.

MGRM was over hedged becauseshort-term oil futures prices tend to bemuch more volatile than prices onlong-term forward contracts.

Edwards and Canter find that thecorrelation between them isapproximately 50 percent.

Hedging strategy was speculative inits design and intent.


21/25

Although German accountingstandards and the contango marketboth contributed to MG's problemsbut true problem with MGRM wasthe size of their position.

The Avg trading Volume is 15000 to30000 contracts per day.

MGRM reportedly holding a 55,000contract position in these contracts.

Wherever the truth lies, MG'sSupervisory Board shares the blame

for this situation.


22/25

Deutsche Bank was not only acreditor to MG but also one of itslargest shareholders.

Deutsche Bank executive, RonaldoSchmitz, was chairman of MGs board

of supervisors at the time.

Experts in derivatives, notably thelate Merton H. Miller, a Nobel-winning economist, argued thatDeutsche Bank was to blame because

it panicked.

Unrealized Gains would have resultedin 170 Million Loss Rather than 1.5Billion .


23/25

The management of MG would have benefittedfrom implementing the recommendations putforth in the Group of Thirty Derivatives study.

These recommendations are basic, but theblatant disregard for these principles cost MG amere $1.5 billion.

Every Few Weeks Companies lose money byeither speculating or by having lack ofhedgeratio understanding.


24/25

MG's disaster in the oilmarkets should be seen as aReminder to the corporate

community to understand thenature of their positioninfinancial markets and to

understand the ramificationsof market movements on yourfinancial positions.


25/25

mg's derivatives

Documents